Do Shareholders Actually Have “Contracts” with Delaware Corporations?

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Legal scholar argues that Delaware’s longstanding use of contract metaphor should be fixed.

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In a state where the number of registered corporate entities outnumbers the population, Delaware’s status as the “corporate capital of the world” is well known. Yet recently, a tenet of Delaware’s treatment of corporate governance—the “system of rules, practices and processes by which a company is directed and controlled”—has been criticized by one of the field’s top legal scholars.

In a forthcoming article, Jill Fisch—a professor at the University of Pennsylvania Law School and Co-Director of the Institute for Law and Economics—takes aim at a long-accepted metaphor used to justify Delaware’s deference to corporate governance rules. Using a rationale known as the “contractual approach,” Delaware takes a deferential approach when reviewing corporate bylaws because these rules metaphorically act as consensual contracts among the corporation’s participants, which include shareholders, officers, and directors.

Although Fisch acknowledges that there is a long history of legal scholarship supporting the contractual metaphor, she also argues that Delaware legislators and courts overstate how well the metaphor captures reality—a flaw that she suggests may be remediated by either modifying Delaware law or the deference courts have given to board actions.

Fisch traces the concept of judicial deference to corporate bylaws to legal scholarship from over twenty-five years ago. Giving continued relevance to this scholarship, Delaware judges have recently held that owning stock represents a form of “implied consent” to a company’s governance structure because shareholders must purchase stakes in public corporations based on market-driven prices. If shareholders ever come to disagree with the governance structure, they can simply sell their shares.

The contractual approach has been popular within the realm of Delaware corporate law for several reasons.

First, scholars argue that a “one-size-fits-all approach” to corporate regulation would be inefficient given the differences between the million or more corporate entities that exist or which are organized in Delaware. Under a contractual approach, though, corporations have more flexibility to issue firm-specific terms that shareholders can consider when purchasing stock.

Second, Delaware’s statutory grant of the ability to adopt, amend, and repeal bylaws further supports a fluid contractual relationship between shareholders and directors. Delaware mandates that each corporation grant shareholders the ability to change bylaws, and a “vast majority” of Delaware corporations also give the directors the ability to do the same. Thus, market pressure as well as statutory mandate have both contributed to Delaware courts’ deference to the way corporations regulate themselves.

Although great in theory, the contractual approach has several flaws in reality, Fisch claims.

She argues that “shareholder power to amend bylaws is more limited than” Delaware courts have suggested. Relating to the contractual approach, she contends that “shareholders do not enjoy analogous power” to the broad powers that corporate boards have over governance bylaws. Providing a statutory example, Fisch highlights Delaware’s restriction on a shareholder’s ability to propose a bylaw which “impedes the Board’s exercise of its” duties to manage the business of the company. She also cites Delaware case law that plainly states that “stockholders’ ability to amend bylaws is not coextensive with the board’s concurrent power and is limited by the board’s management prerogatives under” Delaware law.

Moreover, Fisch also points to other Delaware cases that suggest shareholders do not have equal footing against boards. For example, Delaware courts have refused to endorse insulating shareholder-passed bylaws against repeal from boards. Although other corporate law schemes specifically allow for this, Fisch documents that Delaware has so far viewed the protection as an “obvious conflict.”

Further, even if board-passed bylaws do not receive preferential sway, Fisch argues that practical considerations—such as issues with stockholder voter turnout and supermajority voting requirements—still depict an asymmetry against shareholders. Leo E. Strine, the Chief Justice of the Delaware Supreme Court, has recognized, in a recent case, that “Practical realities of stock market ownership have changed in ways that deprive most stockholders of both their right to voice and their right of exit.” Fisch notes that changes in size and disbursement of the typical pool of shareholders have a particular impact on the balance of power between shareholders and boards.

Given the unrealized asymmetry between the board and shareholders’ ability to make changes to corporate bylaws, Fisch contends that current Delaware “deference that is based on the analogy to contract principles may be inappropriate.”

Fisch identifies two possible remedies to correct the asymmetry. One is to “level the playing field” for shareholder authority. She argues that modifying Delaware law could equalize shareholder authority with board control over bylaws. Specifically, she recommends eliminating restrictions on shareholder’s ability to propose certain bylaws, such as the restriction on bylaws relating to the board’s control of the business. Further, she recommends enhancing the tenacity of the bylaws shareholders do propose, such as allowing for insulation against board repeal.

Alternatively, Fisch suggests that Delaware courts could increase their scrutiny of board-adopted bylaws. On the one hand, increased scrutiny seems to contradict Delaware’s general deferential approach. Yet Fisch argues that enhanced “oversight of board-adopted bylaws would not be unworkable.” She cites to Delaware case law that demonstrates that Delaware courts already administer increased scrutiny in other areas of corporate law. Specifically, Fisch argues that since the Delaware Supreme Court has successfully implemented a two-part review of board-adopted antitakeover actions, implementing a similar review towards board-adopted bylaws that diminish shareholder rights could also succeed.

Given that Delaware is home to “more than half of all U.S. publicly traded companies,” any judicial deference given to how Delaware corporations govern themselves affects millions of shareholder lives. Thus, for a state that is intentionally recognized for its corporate jurisprudence, it may be time for Delaware legislators and judges to reexamine the reliance on a decades-old theory and consider deferring to the recommendations made by Jill Fisch instead.